The Fed Weighs In

Since it began its various quantitative easing programs several years ago, the U.S. Federal Reserve has become one of the largest creditors to the United States federal government, funding around half of the massive amount of debt issued by the U.S. Treasury to sustain government spending at greatly elevated levels since 2009.

Having become such a large holder of the national debt, and because the nation’s central bank would be counted upon to be the government’s creditor of last resort, loaning money to the government at low interest rates that no one else will, the Fed has an obvious interest in anticipating how much new debt the federal government will generate in the future.

That’s the subject of the March 2014 Economic Letter produced by the Dallas branch of the Federal Reserve. Jason Saving, a senior research economist for the Fed, describes what the Fed expects will happen under current law, in both the short term and the long:

Over the next 10 years, annual deficits might be expected to gradually decline as the recession’s aftereffects increasingly enter the rearview mirror and the “targeted, timely and temporary” short-term stimulus measures intended to combat the recession fade to insignificance. This expectation would certainly be consistent with both 2013’s marked reduced deficit and expected declines in 2014 and 2015. Further, support for this view would be provided by the pickup in revenue from 60-year lows and measures—such as the recent two-year budget agreement—that, at least ostensibly, reduce annual deficits.

However, this outlook turns out not to be the case. After bottoming out at 2 percent of GDP during 2015–18, annual deficits are projected to rise with each succeeding year, reaching nearly 3.5 percent of GDP by 2023. The primary reasons: the retirement of baby boomers, which raises entitlement outlays (Social Security and Medicare), and an expectation that interest rates will rise sharply over the next decade, dramatically increasing U.S. borrowing costs.

What about further down the road? Under a “current law” scenario (under which Congress makes no adjustments to the existing policy environment), deficits would grow inexorably over time, rising to 6.4 percent in 2038, reaching 14.2 percent of GDP by 2088.

Saving produces the following chart to show how deep the hole dug by running persistent deficits year after year becomes, as a percentage share of GDP:

Saving also identifies the main drivers for those ever increasing annual federal budget deficits:

Entitlement spending would grow at roughly the same pace over that period, driven mainly by the interplay of an aging population with ever-more-expensive medical technology. This is no coincidence, because it is precisely this growth in entitlement programs (and to a lesser extent a sizable increase in interest payments) that causes long-term deficits to soar.

Saving then describes the economic impact of running up the national debt through those ever increasing budget deficits (emphasis ours):

The accumulation of historically high federal fiscal deficits over a prolonged period is significant for at least three reasons. First and perhaps most obviously, large and growing deficits directly increase the interest payments required to service them, requiring sacrifices (or higher taxes) elsewhere. Second, an abundance of economic research illustrates that increased borrowing eventually “crowds out” competing demands for capital from private investment, relegating the economy to a lower growth path. Future generations will face a lower standard of living than they would otherwise experience. Finally, carrying a higher stock of debt makes it more difficult for government to respond appropriately when the next recession occurs. Indeed, this was precisely the situation faced by the U.S. after running historically unprecedented peacetime deficits during 2001–08.

These are all points that we’ve emphasized here at the MyGovCost blog for quite some time. It’s just really nice to see that at least one person at the Fed gets it!

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